What’s “Top Of Mind” At Goldman? One Thing And One Thing Only

Needless to say, geopolitical risk should be “top of mind” for anyone who fancies themselves a serious market participant/commentator.

True, DM central bank liquidity and jawboning (read: forward guidance tweaking) have thus far managed to suppress the market’s response in terms of volatility, but as it turns out, what central banks can’t do is keep Pyongyang from launching ballistic missiles, keep Nazi-sympathizers from marshaling an alarming percentage of the vote in France, bridge the sectarian divide in the Mideast, keep Erdogan from declaring himself Sultan, and/or keep Donald Trump from burning down Washington.

So while markets may be conditioned to effectively ignore what’s going on in the world, that doesn’t change the fact that things are getting more unstable virtually by the hour (witness the manic news cycle). Eventually, this will catch up to markets because again, central banks can’t ultimately control geopolitical outcomes.

They can try to mute the impact or short-circuit their potential to effect asset prices, but one of these days, something’s going to happen that they simply can’t blunt. That’s whenit all goes horribly wrong for the vol sellers.

Well, as we said at the outset, this should be “top of mind” for everyone figuratively speaking, but it’s “top of mind” literally for Goldman on Tuesday:

Below, find the executive summary from the note along with some compelling graphics…

Via Goldman

Escalating tensions around North Korea’s nuclear ambitions, increasingly prolific and sophisticated cyber-attacks, and souring US-Russia relations—not to mention ongoing instability in the Middle East—have made geopolitical risk Top of Mind. In fact, a recent Goldman Sachs survey showed that one-fifth of investors saw North Korea developments as the US political issue that would have the most impact on markets in May, second only to tax reform. Yet risky assets have generally performed well amid these geopolitical concerns (even the KOSPI is up about 13% YTD).

So are concerns about geopolitical issues—and North Korea in particular—overblown? Or is it simply that the markets don’t care?

We ask the first question to US Ambassador Christopher Hill, whose past diplomatic postings include South Korea and Iraq. In his view, geopolitical risk is elevated right now, creating a number of strategic challenges that the Trump administration is not fully equipped to handle. Looking across the many threats to international security today, from terrorism to armed conflict, Hill argues that weak or uncertain command and control over nuclear weapons is the most worrisome. And nuclear advances in North Korea under a leader who “has little interest” in US or Chinese opinions mean this threat has grown considerably.

Having led the US delegation in six-party talks with North Korea in the mid-2000s, Hill commends the Trump administration’s focus on the issue but acknowledges that the potential for retaliation limits prospects for US action against Pyongyang. He argues that China must do more to rein in North Korean nuclear ambitions, but that sanctions alone may not work; in fact, they may accelerate nuclear weapons development. Rather, multitiered pressure from China together with the United States would provide the best chance of a denuclearized North Korea.

Given the pressure on China to take a major role in reining in North Korea, we also interview Ren Xiao, Director of the Center for the Study of Chinese Foreign Policy at Fudan University, for Beijing’s perspective. He believes many in China’s foreign policy community see North Korea as a genuine security risk and only a nominal ally. But he asserts that China alone should not be expected to solve the North Korean issue. And Beijing’s willingness to do so in cooperation with Washington has arguably waned given the decision to deploy the Terminal High Altitude Area Defense (THAAD) system in South Korea. In his view, the United States and North Korea must do the hard work of negotiating a diplomatic solution.

So with all this tension around North Korea, assets in the region must be selling off, right? Not so much. In fact, the KOSPI reached an all-time high last week, and the trade-weighted KRW shows little sign of recent tensions. What gives? GS CoChief Markets Economist Charlie Himmelberg and Senior Asia Economist Goohoon Kwon believe that markets have become accustomed to geopolitical tensions waxing and waning, with rewards (usually) going to those investors who buy the dips. This mentality seems to be prevailing today, as even the most convincing evidence of markets pricing North Korea risk— elevated KRW/USD skew—looks somewhat modest (see above).

We sat down with Sandy Rattray, co-developer of the VIX and now the CIO of Man Group, to dig further into the seeming disconnect between high geopolitical and other risks and exceptionally low volatility, as well as the potential for popular trading strategies (think passive investing or volatility selling) to exacerbate market reactions to a tail-risk episode. In short, he believes volatility has remained low because some of the mostwatched “tail events” have so far turned out better for markets and economies than many observers expected (think Brexit). While he does not see shifts in trading strategies creating distortions in the market, he cautions that short-vol strategies pose significant risks if not managed appropriately.He strongly believes that the current low-vol environment is not a “new normal,” meaning that investors who aren’t prepared for its eventual end—whether through their asset allocation mix or more direct hedging strategies—are very likely to fare poorly.

We also look into an obvious set of assets tied to geopolitical risk: Defense and Cybersecurity stocks, and gold. GS Aerospace and Defense Analyst Noah Poponak observes a clear relationship between geopolitical escalations and defense spending, but reminds us that the defense budget was already inflecting from its recent trough, a key driver behind his Attractive view on the Defense sector.

Security Software Analyst Gabriela Borges highlights two stocks exposed to cyber: FEYE and VRNT. And Jeff Currie and Mikhail Sprogis of GS Commodities Research ask whether gold is truly a good geopolitical hedge. Their answer: It can be if the event involves currency debasement, but implementation is important. This analysis, however, doesn’t take into consideration gold market liquidity itself, which can be crucial when deciding to hedge via physical gold in a vault versus COMEX gold futures. Using a gold futures contract as the basis of the hedge makes the implicit assumption that market liquidity will not be a problem in the realization of a geopolitical event. The importance of liquidity was tested during the collapse of Lehman Brothers in September 2008. Gold prices declined sharply as both traded volumes and open interest on the exchange plummeted. After this liquidity event, investors became more conscious of the physical vs. futures market distinction and began to demand more physical gold or physically-backed ETFs as a hedge against black-swan events. The lesson learned was that if gold liquidity dries up along with the broader market’s, so does your hedge—unless it is physical gold in a vault, the true “hedge of last resort.”

Writing about a subject is the best
way to educate yourself about it, and when I flick through past work I remember how much
they taught me, if no one else. Mainly they taught me that I didn’t know very much. But they
also taught me that most other people didn’t know much either. Thus, some key themes
which stand out include the illusory control of policy makers, the presumed knowledge of
those looking to them to actively do good, the ease with which we fool ourselves, and how
best to protect capital in the face of such unavoidable uncertainty. -- Dylan Grice